Why paying taxes isn't always bad

Oftentimes, small business owners tell me they want to pay as little in taxes as possible. I get it: no one wants to give Uncle Sam more than his fair share. The amount of taxes paid is also an easy metric to assess: it’s right there on your tax return and you wince when you have to write the check for it.

Minimizing taxes should, however, be a secondary objective, not a primary goal for a business. Here’s some ways that focusing on the taxes paid can hurt a small business:

Unprofitable investment

The most obvious trap that arises from focusing on minimizing taxes is taking a business’s focus off profitability. The easiest way to minimize your taxes is to lose money, but of course that’s not really a sustainable strategy for the long term. By focusing on the amount of taxes paid rather than the post-tax income or loss, you might make some poor decisions that can come back to haunt you.

The most common example of this is buying new equipment or other assets that can be depreciated immediately. Remember: just because you can write off that new tractor doesn’t mean you should. If the additional investment will make your business more profitable, go ahead! But in the name of avoiding taxes, business owners often buy equipment they don’t need. This is sometimes called “spending a buck to save a nickel,” and it can lead to a yard full of the world’s most expensive paperweights.

Not paying into Social Security

If you report your business on Schedule C or F, you pay self-employment taxes on your net earnings. By keeping taxable income low, you avoid paying the 15.3% self-employment tax, but you also are not contributing as much towards your earnings record. If done consistently over the course of a career, you might find your Social Security payments fall short of what you need.

Many are worried about the solvency of the Social Security system, but that’s a topic for another time. If you’re concerned about not being able to rely on Social Security for your own retirement, that’s fair enough, but in that case the solution should be to save more outside of the system, not to minimize profits today, which leads us to the final danger:

Not saving enough outside of your business

If you focus on minimizing your taxable income year after year, you are likely pouring profits back into the business, often in the form of purchasing depreciating assets. This can leave you with little to show for your savings outside of your business, a highly undiversified and potentially illiquid position to be in.

Many farm families experience this effect, sometimes referred to as being “balance sheet millionaires,” but without the cash to pay bills. One business owner I spoke to said he was looking to retire but needed to sell his business for a million dollars since it was his “nest egg.” The problem is that the value of your business is often based on many factors outside of your control and your ability to tap that value when you need it may be limited.

Setting better goals

Since minimizing tax paid each year can have so many pitfalls, what should you focus on instead? I believe you should consider your goals and then optimize for a balance in two areas:

• Running a healthy business

• Long-term planning

Running a healthy business

First, you should make sure you have a strong grip on what makes your business profitable. Are you currently producing a profit? If not, what needs to be done to reach profitability. Sometimes, additional investment is the cure needed. At other times, rather than more investment, your business needs to trim down unnecessary or unprofitable activities.

For example, let’s say you run a window cleaning business, and you discover that you make $100 per window you clean for commercial clients and lose $50 for every window cleaned for residential clients. Investing in equipment that enables you to clean more commercial windows could make a lot of sense. If you invest in a machine that lets you clean twice as many residential windows, however, you’ll be losing money twice as fast as before!

You may also need to consider your near-, medium-, and long-term goals for the business. If you’re getting started and breaking into a market with lots of room for growth, you may not show much profitability early on and may even have to subsidize the business with outside income. Once you reach the scale you’re happy to operate at, however, it may be time to start “harvesting” some of those profits, even if it means paying the taxes. The trap to avoid is pouring money into investment that doesn’t produce growth. At some point, your business ought to produce a surplus that you can invest elsewhere.

Long-term planning

The second area to consider can be much more challenging. The future is impossible to predict, and few enjoy planning for a day when they cannot work as they do now. Someday, more likely than not you will need to draw more income than you produce, so you need to have at least a rough plan for how you will do so. Relying on selling your business outright to fund your retirement may leave you in a tough place right at the time your human capital is most limited.

What’s more, if you dream of passing your business on to the next generation, not drawing enough income from the business to have outside savings may prevent that from happening. I once heard a farm succession counselor say that in most successful generational transitions he had worked with, the current ownership generation had sufficient investments outside of the business to replace 50% of their profits from the business. This meant they had vital flexibility in arranging the financial side of the transition since they were not relying entirely on the income from the farm to sustain them.

Conclusion

No one wants to pay more than they need to in taxes, but don’t let the tax tail wag the dog and prevent you from setting and pursuing long-term goals for your business and life. This year, focus on serving your community, family, and successors well by developing a business plan that produces enough surplus to pay taxes and still leave you with a healthy profit. Once you have that plan in place, then it's time to talk about how to minimize the taxes while still achieving your goals.

Here's where I'm supposed to insert a little ad for my services and how I can help you solve all of this, but (1) mostly this requires you to sit down and think it through for yourself, and (2) we all see too many ads as is. If you're on my site, you probably are aware of what I do, but if not you can check out my services page.

The information provided on this blog is for general educational purposes only and should not be taken as tax, legal, or financial advice. Tax situations vary, and you should consult a qualified tax professional for guidance specific to your circumstances.